In many ways, of all fields of knowledge, Economics and finance have the greatest impact on our daily lives. We use it constantly and we should know how it works.

Also, it’s fun.

And now, a footnote:

Where RollingAlpha Came From: The Allan Gray Backstory

As I mentioned above, I am part of the CA (SA) crowd. Part of that membership required my early years to be spent in the world of auditing – which is a mostly fun place, except for the fact that almost all of your work requires you to be an annoyance to a client.

And my favourite part was the two months of the year that I got to spend at Allan Gray. For the non-South African readers, Allan Gray is one of our big asset management houses. They’re contrarian; they’re successful; they have great offices at the V&A Waterfront in Cape Town; they have espresso machines on every floor; and most importantly, they have a really excellent canteen for staff lunches. Also, the finance department staff didn’t get annoyed with you asking questions – they got annoyed with you for asking stupid questions. And if your questions were foolish enough, there was every chance that a request would be made for your removal from the audit team.

Basically, Allan Gray was the audit-client equivalent of those kids that sit in the front of class, looking forward to tests and exams because they always get the highest mark – and they really like getting the highest mark, and they like to see that in writing. But if you mark them wrong, then you had best triple-check your own solution, because they’re probably right – and if you mark them wrong in error, then they WILL BE complaining about your inadequacy as a teacher/lecturer to an HOD because, well, if you’re marking their paper, then you really should know what you’re doing.

It was heaven.

And it was in an Allan Gray audit meeting that I first heard someone use the phrase “maintain our alpha”. Which was one of those rare moments where I exulted in knowing what they were talking about. In fact, I think I was even invited to explain it #proudmoment

And here we are. I’m re-enacting that moment.

Talking about “Alpha”

So the official definition of “alpha” sounds something like “the extra return generated for any given level of risk”.

To explain that, let me give you an example:

Let’s say that I play a game of coin-tossing.

In the game, I get to flip a coin 10 times.

If I win a toss, then I earn $3; and if I lose, then I have to pay out $2.

Because the coin only has two sides, the odds are that I’ll win half the time, and lose the other half of the time.

So over 10 coin tosses, I’ll expect to win five coin tosses (and earn $15) and lose the other five (and pay out $10).

Meaning that, overall, I expect to earn $5 ($15 – $10) in the game.

But let’s say that the Universe is in my favour, and in a particular game, I win seven coin tosses.

I’ll receive $21 for the seven wins, pay out $6 for the three losses, and end up earning $15 overall.

Based on the risk that I took on (the 50:50 odds), I expected to earn $5. But I actually won $15. That extra $10 – that return over and above the $5 that I expected to earn – that is positive “alpha”.

And Why Alpha Must Roll

The problem with that $10 alpha is that it might just be a lucky break in this particular game. And based on the probabilities involved: the more times I play the game, the closer I’ll get to earning $5 per game on average.

This is where the “rolling” part comes in – because if I’m a bit prescient, and I’m able to beat the odds by regularly/repeatedly winning 7 out of 10 coin tosses, then that is called “rolling alpha”.